Central banking, , and financial stability, Lecture, Summer 2009, Technical University of Berlin, Ulrich Bindseil, European

2. An overview of financial crises and the role of liquidity and central banks

A. Large asset value losses ...... 1 B. Declines in asset values create capital constraints and increases default probability of financial institutions ...... 9 C Spill over into a liquidity crisis ...... 12 D. : reduced lending to the real sector ...... 18 E. Mapping the financial system into accounts ...... 20 F. Wrap up questions ...... 23

We will try to gain an overview of . What is causing them? What is a liquidity crisis? What phases can typically be observed? And what can cure a crisis? From the start, we will focus in particular on the liquidity dimension of crises, as this is where the central bank will be supposed to play a major role. We get inspiration from some 19th century literature (e.g. Bagehot). If features described long time ago still appear to apply today, we may want to believe that they must be quite general.

A. Large asset value losses E.g. Bagehot (1873), Wirth (1883), or Kindleberger and Aliber (2005) all highlight the key role as a trigger for most financial crisis of a serious downward revision of asset values and of the general perception of the worth of projects and the general economic prospects. The starting point of this downwards revision is often linked to what is considered ex post to be an asset bubble, relying on an overestimation of some innovation plus a general trading hype. In theory at least, an asset price can be separated into a component determined by underlying economic fundamentals and a non-fundamental bubble component that may reflect price speculation or irrational euphoria or depression. The expansion of an asset price bubble may lead to misallocation of economic resources, and its collapse may cause severe strains on the financial system and destabilize the economy. Of course, asset values can also crash on the basis of substantial fundamental bad news, and this can also suffice to trigger a financial crisis. A few examples In the current turmoil, the break of a trend in real estate prices plays a key role. The following chart on UK housing prices (BoE financial stability review of November 2008) suggests that in 2007, a long term exceptional upwards trend in house prices ended. The second chart, which is due to Paul Krugman (11 October 2008, NY Times blog), suggests a dual asset price bubble burst for the US:

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Also the unprecedented “L-shaped” Japanese stagnation ever since 1990 was the result of an unprecedented real estate and equity bubble. Real assets affect the value of financial assets that are linked to those real assets. In the case of the current crisis, securities relating to mortgages were unsurprisingly particularly hit. The following table provides losses as estimated in October 2008 of debt securities values (IMF, 2008, 15):

In January 2009, the IMF provided an update with a total loss estimate of USD 2.2 trillion (instead of the USD 1.4 trillion in the table above). For the most hit asset class, ABS containing sub-prime mortgages, the chart below provides an idea of the extent of losses, according to rating grades (table from: M.K. Brunnermeier, 2009, “Deciphering the liquidity and credit crunch, 2007-08”, working paper, Princeton).

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The losses on fixed income securities are of course only one part of the financial asset value losses. Global stock markets would have lost about $28.7 trillion in 2008 (around 40% of their value), exceeding by far the estimates on fixed income assets losses (although relatively more attention has been given to fixed income assets maybe because the banks’ share of holdings of stocks is lower, and hence financial stability consequences are more moderate?).

Bubbles burst because realise they over-estimated asset values Already Bagehot (Chapter 6), mocks about the absurd projects which were promoted and believed at the occasion of the South Sea Bubble of 1720, but that necessarily must have lead to a crash as soon as investors became realistic again:

“But, in fact, in the South Sea Bubble, which has always been remembered, the form was the same, only a little more extravagant; the companies in that mania were for objects such as these:' "Wrecks to be fished for on the Irish Coast—Insurance of Horses and other Cattle (two millions)—Insurance of Losses by Servants—To make Salt Water Fresh—For building of Hospitals for Bastard Children—For building of Ships against Pirates—…—For extracting of Silver from Lead—…For a Wheel of Perpetual Motion." But the most strange of all, perhaps, was "For an Undertaking which shall in due time be revealed." Each subscriber was to pay down two guineas, and hereafter to receive a share of one hundred, with a disclosure of the object; and so tempting was the offer, that 1,000 of these subscriptions were paid the same morning, with which the projector went off in the afternoon.' In 1825 there were speculations in companies nearly as wild, and just before 1866 there were some of a like nature, though not equally extravagant..” This account contains several key aspects described again and again to hold for financial crisis built-ups: overestimation of projects or of the general economic prospects, leading to too high asset values, speculative mania, and market price dynamics.

3 Similar recent cases of asset bubbles which were mainly driven by overly optimistic assumptions on the fundamental value of projects were • The German Third Generation cell phone auctions in 2000 in which EUR 105 billion were achieved as auction proceed, but the six winning companies realising soon that they had hugely overpaid the licences, or the • general dotcom-boom, as exemplified in Germany by the Neuer Markt. Its index, the Nemax, stood in March 2000 at 9666 points, and in October 2002 at 318 points, achieving an impressive minus of 96%. A comprehensive statistical overview of housing and equity market bear markets in industrial countries is provided by T. Helbing and M. Terrones (2003, “When bubbles burst”, World Economic Outlook, IMF, April 2003, Chapter II).

Irrational exuberance or rational uncertainty? Why do intelligent professionals overestimate (from an ex post perspective) the value of projects? Two possible answers: • Irrational exuberance: Investors become collectively irrational at some stage, and also through the game of the market (be it the stock exchange or an UMTS auction) bid each other up. Maybe some or even a relevant share of individuals realise that prices are overstated, but they still play the game because as long as it continues, it appears profitable (but people appear naively to believe that they all can get out in time?). • Rational uncertainty: even if thinking carefully, it is not clear ex ante to distinguish the good from the bad project (and hence the overvalued from the fairly valued asset). Hence, ex post critique would be rather cheap and irrelevant. This view relates to the efficient market hypothesis that markets aggregate existing information in an efficient way.

According to an ECB monthly bulletin article of 2005, it is on one side hard to find strong systematic evidence in favour of the irrationality hypothesis, while on the other side from an ex post perspective it is easy to find episodes in which "valuation indicators were clearly out-of-line with respect to their long term averages" (p. 51). Supporting the “rational uncertainty” theory, it may be noted that for a fixed asset with a duration of -flows of 20 years, a change in the (rationally) assumed growth rates of cash flows can indeed be quite dramatic. When markets grow very quickly, as it can be assumed for new pervasive technologies, a change of expectations from e.g. 20% to 5% has a dramatic effect, as summarised in the example of the following table.

4 Assumed Net present value of project growth (cash flow in Y1 = 100 rates of discount rate = 5% cash flow 20 years horizon) 5,0% 2.000 7,5% 2.524 10,0% 3.225 12,5% 4.164 15,0% 5.427 17,5% 7.126 20,0% 9.414

Take the following two famous examples from the former Fed-Chairman Greenspan, who reveal him to be more of a believer in the “rational uncertainty” school. First, consider his “irrational exuberance” comment, which triggered a temporary slump in stock prices, was made on December 5, 1996: “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? [...] ” He took this question up in more detail in another speech on September 4, 1998, entitled: “Question: Is There a New Economy?” “The question posed for this lecture of whether there is a new economy reaches beyond the obvious: Our economy, of course, is changing everyday, and in that sense it is always "new." The deeper question is whether there has been a profound and fundamental alteration in the way our economy works that creates discontinuity from the past and promises a significantly higher path of growth than we have experienced in recent decades. The question has arisen because the economic performance of the United States in the past five years has in certain respects been unprecedented…. Some of those who advocate a "new economy" attribute it generally to technological innovations and breakthroughs in globalization that raise productivity and proffer new capacity on demand and that have, accordingly, removed pricing power from the world's producers on a more lasting basis. There is, clearly, an element of truth in this proposition. … In summary, whether over the past five to seven years, what has been, without question, one of the best economic performances in our history is a harbinger of a new economy or just a hyped-up version of the old, will be answered only with the inexorable passage of time. And I suspect our grandchildren, and theirs, will be periodically debating whether they are in a new economy.” Chairman Greenspan remained agnostic, him, the personification of economic wisdom, could not say if the high asset values perceived in the 1990s were justified or not. Some criticised this view early, such as e.g. Robert Shiller in 2000 when publishing his book “Irrational exuberance”. But how could we know that he is not just a “survivor”? What about the many other books arguing the contrary? For instance Kindleberger and Aliber (2005, 58) report about three books published in 1999 by serious publishing houses with titles like “Dow 36,000: the New Strategy for

5 Profiting from the coming rise in the stock market", "Dow 40,000: Strategies for profiting from the Greatest Bull Market in History” and “Dow 100,000: Fact or Fiction”.

The role of ample credit and loanable capital Moving closer to a role of central banks in asset crisis: Often, asset bubbles seem to have been triggered by “ample liquidity”, and again we can start by quoting Bagehot (1872, Chapter IV, in line with the other historical accounts): “In most great periods of expanding industry, the three great causes—much loanable capital, good credit, and the increased profits derived from better-used labour and better-used capital—have acted simultaneously; and though either may act by itself, there is a permanent reason why mostly they will act together.” “And in so far as the apparent prosperity is caused by an unusual plentifulness of loanable capital and a consequent rise in prices, that prosperity is not only liable to reaction, but certain to be exposed to reaction.” According to Laeven and Valencia (2008, 19) who collected data for a sample of 107 banking crises, banking crises are also often preceded by credit booms, with pre-crisis rapid credit growth in about 30 percent of crises. Average annual growth in private credit to GDP prior to the crisis is about 8.3 percent across crisis countries. Credit booms also have often been preceded by processes of financial liberalization, such as the one that led to the crisis in the Nordic countries in the 1990s. It may also be caused by too lax central bank policies – this has been reproached to the Greenspan’s Fed.

Can central banks create asset price bubbles? For central bankers, it is of course a key question if they can cause a credit and asset value boom by keeping interest rates too low. The answer is probably yes (unless we assume some strong form of neutrality of money, of course). Consider the following arbitrage diagram showing two goods (wheat and money) at two points in time (today and tomorrow) and with the relevant relative prices.

6 Following Wicksel (1898, Geldzins und Güterpreise) or Richter (1990, Geldtheorie), an arbitrage logic allows establishing some basic relationships between relative prices by moving within the diagram from one good to another via different paths. Indeed, by moving from W1 to W2 through different ways, one can show that in equilibrium: 1+r = P1/P2 = P1(1+i) / P2* Defining (1+ π) as P2*/P1, we also obtain the Fisher equation: (1+r) = (1+i) / (1+ π)

If the central bank manages to keep the money rate i always equal to the real interest rate r, no inflation should occur (whereby this diagram only considers one capital good). Of course this is an arbitrage diagram, and a financial crisis is clearly an example of disequilibrium. Still, it allows to understand what may happen if the central bank starts suddenly setting money interest rates at a too low level. In this case, and assuming that economic agents cannot observe the real interest rate, but trust the central bank that it will manage to keep inflation rates low, an apparent arbitrage appears, since 1+r > (1+i)/(1+π), and hence by borrowing money today, buying wheat today, investing it, and obtaining wheat tomorrow and selling it tomorrow, one can make a profit. If prices (inflation) react with a time lag, then there will be some “overinvestment” into wheat, etc. There is no point trying to bring this example to an end, since the arbitrage diagram does not have many elements which are relevant here. Still, it shows the (obvious) idea that the central bank, by setting the money interest rate, will create disequilibrium and dynamic developments, which will include price instability, and in the extreme an asset bubble and a subsequent crash. Amongst those claiming that the Fed caused the current crisis through creating asset bubbles are Paul Krugman and Fleckenstein and Sheehan (2008, “Greenspan’s bubbles”). The latter argue (page 3): “Greenspan erred by continuously picking an interest rate that was too low, the he solved the turmoil that resulted from that decision with another period of interest rates that were again too low. The result was that during his reign, the United States experiences a bubble of stocks and then in real estate. These two massive bubbles emerged within 10 years of each other. Prior to Greenspan’s arrival at the Fed… the country had been bubble-free for over 50 years.” Also Taylor (2007) took this view: “However, a careful review of interest rate decisions shows that in some years they did not correspond so closely to such a policy description. During the period from 2003 to 2006 the federal funds rate was well below what experience during the previous two decades of good economic macroeconomic performance… would have predicted. Policy rule guidelines showed this clearly. There have been other periods .. where the federal funds rate veered off the typical policy rule responses—in particular during the fall of 1998—but this was the biggest deviation, comparable to the turbulent 1970s. Many have argued that these low interest rates—or the provision of large amounts of liquidity that they required—helped foster the extraordinary surge in the demand for housing.” Of course the supply of “loanable capital” to the real sector is not only due to the central bank interest rate, it also depends on the financial system. The financial system may, everything else equal, tend to lend more than usual for a number of

7 reasons: (i) overestimation of project values (e.g. of future house price developments); (ii) improved financial technology (e.g. through better IT and risk management technique, the banks feel confident to lend more with same risk and same financial resources). Subprime CDOs combined the two: the belief into a new financial technology (securitisation and even multi-layer securitisation), and the overestimation of the value of underlying mortgage assets. Similarly, SIVs reflected a believe in a new technology to operate with an undiversified maturity mismatch as short term capital markets would always be available – from today’s perspective a case of hubris.

Can central banks stop asset price bubbles? It is another, not less interesting question, whether central banks can stop asset bubbles emerging from non-central bank causes. According to Glenn D. Rudebusch (FRBSF Economic Letter 2005-18; August 5, 2005 Monetary Policy and Asset Price Bubbles): “The appropriate monetary policy response to an asset price bubble remains unclear and is one of the most contentious issues currently facing central banks…. Two general monetary policy responses to movements in an asset price have been proposed. I refer to the first as "Standard Policy," because there is widespread agreement that it represents the appropriate baseline policy response. The Standard Policy responds to an asset price only insofar as it conveys information to the central bank about the future path of output and inflation—the goal variables of monetary policy. For example, a booming stock market is usually followed by stronger demand and increased inflationary pressures, so tighter policy would be needed to offset these consequences. Even for the Standard Policy response, it would probably be useful to identify—if possible—the separate fundamental and bubble components of the asset price. In particular, the bubble component may exhibit more volatile dynamics and be a pernicious source of macroeconomic risk, so optimal monetary policy may react more to bubbles than to movements in the fundamental component. The second type of response, the "Bubble Policy," follows the Standard Policy as a base case, but, in certain circumstances, it also takes steps to contain or reduce the asset price bubble. Proponents of a Bubble Policy argue that movements in the bubble component can have serious adverse consequences for macroeconomic performance that monetary policy cannot readily offset after the fact, so it is preferable for central banks to try to eliminate this source of macroeconomic fluctuations directly. Furthermore, because bubbles often seem to display a self-reinforcing behavior, a little prevention early on can avoid later excesses. Choosing between the Standard and Bubble Policies requires answering three questions: (1) Can policymakers identify a bubble? (2) Will fallout from a bubble be significant and hard to rectify after the fact? and (3) Is monetary policy the best tool to deflate the bubble?” Only (2) is clear, if we believe the historical literature. On (1), see the Greenspan speech quotations from 1996 and 2000. On (3): Monetary policy is at least relevant in some sense, and generally, it has been the tendency over the last years of central bank officials to not deny a certain capability of central banks to also look at asset price developments. According to Bordo and Jeanne (2002), whether a “leaning-against the wind” policy is warranted “depends on the economic conditions in a complex, non-linear way. The

8 optimal policy cannot be summarized by a simple policy rule of the type considered in the inflation-targeting literature.”

Can other central bank policies (then interest rate setting) be responsible for asset price bubbles? Many central banks may contribute through other regulatory functions to support or counteract a bubble. For instance, Greenspan has also been attacked in the sense that his market-oriented “ideology” would have prevented him to take regulatory action against obvious malpractice in mortgage lending in 2004-2007. This malpractice would have created additional and non-sustainable lending and thereby would have contributed first to pushing up prices further, and then to create a lot of over-supply through foreclosures. In Congressional testimony on October 23, 2008, Greenspan acknowledged that he was "partially" wrong in opposing regulation and stated, with regard to the malpractices observed: "Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity -- myself especially -- are in a state of shocked disbelief”.

B. Declines in asset values create capital constraints and increases default probability of financial institutions First, asset value declines can have wealth effects on consumers, which trigger an economic downturn and secondary financial stability effects. Let’s however focus in the following on banks.

Effect on capital If Bank Capital is C and Debt is D, and Assets are A, then the central bank may be represented by A = C + D. Assuming that A is volatile (see above) and D is fixed, then C must suffer together with A, and if C < 0, default may occur as the assets no longer allow the debt to be paid off. Default often means that the company is liquidated or reorganised, with debt holders losing parts of their money, and equity holders all of it. When exactly default occurs also depends on liquidity, i.e. a bank may default although being solvent, if it just cannot find the liquid funds in time (see section 3 of the lecture for details). When asset values are uncertain, and eventually crash, then the consequences of this on solvency are amplified through . In this context, it is of course relevant that banks will have paid out the apparent profits relating to an asset price boom to their shareholders (or in the form of bonuses to their employees). In the stylised balance sheet above, A/C is the leverage ratio. According to a study by Liquidatum as of end 2007 reflected in the first chart below, around one half of banks have leverage ratio of more than 20 (range 8-73). The two most leveraged banks at end 2007 according to this analysis were Depfa and Northern Rock. The second chart (from the November 08 financial stability report of the BoE) suggests that leverage has increased historically, although it seem to have stagnated

9 for the last decades. Maybe the long term decline is a consequence of more efficient debt markets and better risk management.

There are further effects that may re-inforce that relatively small exogeneous changes of asset values may make banks insolvent. For instance structured finance instruments (in balance sheets of banks) are themselves often leveraged. In particular junior or mezzanine tranches are quickly wiped out when asset values start deteriorating.

Laeven and Valencia (2008, 18) remind us that also traditional banking products, namely loans to corporates and households may be a cause of balance sheet problems of banks (or, the consequence of de-leveraging attempts), namely the rise of the share of non-performing loans. In their banking crisis database, the share of non- performing loans during banking crisis averaged about 25%, Although they remark that it is not always clear though to what extent the sharp rise of non-performing loans was caused by the crisis itself or whether it reflects the effects of tightening of prudential requirements during the aftermath of the crisis. As the next step, the capital of leveraged financial institutions exposed to asset classes loosing value must suffer. The first of the following charts is again an example from the BoE FSR Nov 2008.

Increase of default probabilities Some banks default, some are rescued, some survive without rescuing, but all banks are perceived to be subject to higher default risks than usual. Bank default will be a subject on its own in the subsequent section of the lecture. Why are bank defaults such a problem? Because sorting out a dead bank is extremely costly and lengthy (good for lawyers, consultancy and audit firms administrating the remains of the defaulted institution), and the creditors of banks not only loose a large part of their claim (“loss-given-default” = 1- recovery ratio), but may also have to wait for years for their recovery – too late possibly to prevent their own illiquidity and default. Recovery ratios for unsecured claims against Lehman are expected to be below 10. The crucial point is that there is no continuity in the decline of asset

10 values in terms of their impact on equity, debt holders, and the rest of the economy. Once the default point is reached, the value of debt and equity crashes suddenly. For instance in the week before the Lehman default, Lehman one year debt traded at a discount of less than 10%, now it is worth less than 10% - the difference is partially explained by the vanishing of rescue expectations, but also by the cost of the destruction of organisational and social capital embedded in a company. Perceived default risks during the current crisis is exemplified through the second of the following chart from the BoE financial stability review.

This second chart provides Credit Default Swap spreads. A CDS is a credit derivative contract between two parties, whereby the buyer makes periodic payments to the seller, and in return receives a payoff if the underlying financial instrument defaults. If a credit event occurs then CDS contracts can either be physically settled or cash settled. - Physical settlement: The protection seller pays the buyer par value, and in return takes delivery of a debt obligation of the reference entity. - Cash settlement: The protection seller pays the buyer the difference between par value and the market price of a debt obligation of the reference entity. The Probability of Default of a bank can thus be extracted from the CDS spread and an assumed recovery ratio: CDS spread = PD * (1- recovery ratio). If the expected recovery ratio is 30%, and the CDS spread is 500 basis points, then the perceived PD would be 714 basis points = 7%. High PDs hurt trust between banks, and therefore leads to far less liquidity in the interbank market, and high spreads (only the latter part, which is the lesser problem, is shown in the chart below). This again increases default risks (due to illiquidity), unless the central bank helps. It is of course noteworthy that what happens at the level of banks’ balance sheets also happens at the level of corporate and household balance sheets, when asset values crash: they may become insolvent and may default. This also has important negative knock on effects, although not on bank lending of course.

Central banks’ role

11 What can central banks do about depleted capital and banks’ default risk? As we will see later on, it is not the role of the central bank to re-capitalise banks. If the central bank is also a banking regulator, it can however regulate capital buffers ex ante by imposing prudent capital adequacy requirements or by limiting leverage. Central banks can moreover contribute to prevent defaults from happening due to illiquidity. This is further explained in the subsequent section.

C Spill over into a liquidity crisis Higher perceived default risks lead to more prudent lending, but then also, beyond that, to a certain general drying up of liquidity. How? We start with a quite extensive number of historical quotes, who have not lost anything of their relevance. (1) Already Thornton (1802) notices the problem of liquidity hoarding and bank runs, and how it relates to a lack of trust: “That a state of distrust causes a slowness in the circulation of guineas, and that at such time a great quantity of money will be wanted in order to effect only the same money payments, is a position that scarcely needs to be proved… When a season of extraordinary alarm arises, and the money of the country in some measure disappears, the guineas, it is commonly said, are hoarded. (p. 99)” “If any one bank fails, a general run upon the neighbouring ones is apt to take place which if not checked in the beginning by pouring into the circulation a large quantity of gold, leads to very extensive mischief” (p. 180).

(2) Bagehot (1873, all of the following from chapter VI “Why Lombard Street Is Often Very Dull, and Sometimes Extremely Excited”) argues that while liquidity crisis can be triggered by various exogenous events, their consequences in terms of a liquidity squeeze tend to be similar: “Any sudden event which creates a great demand for actual cash may cause, and will tend to cause, a panic in a country where cash is much economised, and where debts payable on demand are large. …. Such accidental events are of the most various nature: a bad harvest, an apprehension of foreign invasion, the sudden failure of a great firm which everybody trusted, and many other similar events, have all caused a sudden demand for cash. And some writers have endeavoured to classify panics according to the nature of the particular accidents producing them. But little, however, is, I believe, to be gained by such classifications. There is little difference in the effect of one accident and another upon our credit system. We must be prepared for all of them, and we must prepare for all of them in the same way—by keeping a large cash reserve.” (3) Bagehot also highlights the systemic nature of liquidity crises: “Most persons who begin to think of the subject are puzzled on the threshold. They hear much of 'good times' and 'bad times,' meaning by 'good' times in which nearly everyone is very well off, and by 'bad' times in which nearly everyone is comparatively ill off. And at first it is natural to ask why should everybody, or almost everybody, be well off together? Why should there be any great tides of industry, with

12 large diffused profit by way of flow, and large diffused want of profit, or loss, by way of ebb?”

(4) Bagehot also introduces the concepts of general “Credit” to the understanding of financial crisis:

“Credit—the disposition of one man to trust another—is singularly varying. In England, after a great calamity, everybody is suspicious of everybody; as soon as that calamity is forgotten, everybody again confides in everybody. … In a good state of credit, goods lie on hand a much less time than when credit is bad; sales are quicker; intermediate dealers borrow easily to augment their trade, and so more and more goods are more quickly and more easily transmitted from the producer to the consumer…. The peculiar essence of our banking system is an unprecedented trust between man and man: and when that trust is much weakened by hidden causes, a small accident may greatly hurt it, and a great accident for a moment may almost destroy it.”

Apart from this explanation of drying up interbank markets, there is a number of further explanations why the liquidity situation of banks suffer. Consider these one by one.1

(1) Break-down of unsecured interbank market: “I do no longer lend, because if I need the money myself tomorrow, I will no longer get it” – inferior non- lending equilibrium This problem should not hold for interbank overnight markets, but for all longer maturities. It suggests a co-ordination failure which can in principle be almost independent of higher credit risk (there can be an inferior stable equilibrium). The following chart shows the rate side of such a failure of the unsecured interbank market. The quantity side is shown below (see section on margining).

1 See e.g. Calomiris, and Gorton (1991) for an interesting historical account of banking crisis.

13 While the following is of course not a real representation of the micro-economics of a liquidity crisis, it may be useful to think of a liquidity crisis in terms of a simple strategic game, whereby two alternative explanations appear possible: First, it could be argued that the higher credit risk changes the strategic game represented by the interbank market from one with a stable superior equilibrium (in which all banks – in the example below, two banks, lend actively to realise income), to a prisoners dilemma kind of situation.

Strategic game changes: becomes a prisoners dilemma in the crisis due to higher credit risk

Before Bank II crisis Superior equil. stable Lend Do not lend Lend 4 3 Bank 4 1 1 Do not 1 0 lend 3 0 After Bank II crisis Prisoners dilemma Lend Do not lend Lend 2 3 Bank 2 -3 1 Do not -3 0 lend 3 0

Alternatively, it could be perceived that there are simply two stable equilibria, one superior and one inferior, and that the superior is the pre-crisis one, and the inferior is the one representing the liquidity crisis. We then however admittedly lack a throry of why we move from one equilibrium to another.

Two stable equilibriums, one superior, and inferior Bank II Lend Do not lend Lend 4 3 Bank 4 -3 1 Do not -3 0 lend 3 0

There is quite some microeconomic literature on the break down of interbank markets. A recent paper quoting also other papers is Caballero and Krishnamurthy (2006). Section 2 of Flannery (1996) provides a simple and intuitive model (which may also be presented in the lecture). Akerlof (1970) is also directly applicable and may explain why small changes in uncertainty may drive a market breakdown.

(2) Retail depositors bank runs

14 According to Laeven and Valencia (2008, 19), “bank runs are a common feature of banking crises, with 62 percent of crises experiencing momentary sharp reductions in total deposits. The largest one-month drop in the ratio of deposits to GDP averages about 11.2 percent for countries experiencing bank runs, and is as high as 26.7 percent in one case. Severe runs are often system-wide, but it is also common to observe a flight to quality effect within the system from unsound banks to sound banks that implies no or moderate systemic outflows.” Retail depositors bank runs were experienced in the recent crisis in the case of Northern Rock. Also, banknotes demand in total, indicating a minimal aggregate run, increased from October 2007 to October 2008 by [13%], while they had only increased by [8%] between October 2006 and October 2007. The key theoretical literature reference on bank runs remains Diamond and Dybvig (1983), which has inspired manyfurther paper. To my taste, this literature is somewhat on the too theoretical side, i.e. I find the relation between the complication of the theoretical set up and the intuition eventually gained unfavourable.

(3) Dry up of short term capital markets But the liquidity stress exerted from investors, mainly institutional, went far beyond this, as suggested by the need to refinance ABCPs, and the need to renew maturing bank bonds (leading eventually to the need of state-guaranteed bank bonds). The following is taken from M.K. Brunnermeier, 2009, “Deciphering the liquidity and credit crunch, 2007-08”, working paper, Princeton).

(4) Increase of margins. Geanakoplos (2009, 6-7) highlights the importance of margining for the spill over into a liquidity crisis:

The use of and leverage is widespread. A homeowner (or a big investment bank or hedge fund) can often spend $20 of his own cash to buy an asset like a house for $100 by taking out a loan for the remaining $80 using the house as collateral. In that case we say that the or haircut is 20%, the loan to value is $80/$100 = 80%, and the collateral rate is $100/$80 or 125%. The leverage is the reciprocal of the margin, namely the ratio of the asset value to the cash needed to purchase it, or $100/$20 = 5.

15 A reduction in margins will raise asset prices. Conversely, if margins go up, asset prices will fall. A potential homeowner who two years ago could buy a house by putting 5% cash down might find it unaffordable to buy now that he has to put 25% cash down, even if the Fed managed to reduce mortgage interest rates by 1% or 2%. This has diminished the demand for housing, and therefore housing prices. What applies to housing applies much more to the esoteric assets traded on Wall Street (such as the mortgage investments targeted by the Treasury), where the margins (i.e. leverage) can vary much more radically. Declining margins, or equivalently increasing leverage, are a consequence of the happy coincidence of universal good news and the absence of danger on the horizon. Good, safe news events by themselves tend to make asset prices rise. But they also encourage declining margins which in turn cause the massive borrowing that inflates asset prices still more. Similarly, when the news is bad, asset prices tend to fall on the news alone. But the prices often fall further if the margins are tightened. The rapid increase in margins always comes at the worst possible time. Buyers who were allowed to massively leverage their purchases with borrowed money are forced to sell. But when margins rise dramatically, more modestly leveraged buyers are also forced to sell. Tightening margins themselves force prices to fall.” The following table taken from the IMF Global Financial Stability Report (p. 42) of November 2008 demonstrates the large increase of margins (and the implied needs to reduce leverage) during the present crisis.

The level of margins is not only relevant for asset purchases which are financed by repoing the purchased assets, but also for collateralised interbank lending and the collateralisation of OTC derivative transactions. An overview of the use of collateral in wholesale markets can be found for instance in the annual ISDA margin survey. According to a press release on the 2008 survey, the amount of collateral in circulation in 2008 was USD 2.1 trillion (of which 80% was however cash). The 2008 Survey reports that collateral agreements in place grew to over 149,000, of which 74 percent are two-way agreements. Among firms that responded both in 2007 and 2008, collateral agreements grew by 18 percent. For all over-the-counter derivatives transactions, 63 percent are subject to collateral agreements, compared with 59

16 percent last year. Furthermore, 65 percent of credit exposure for privately negotiated derivatives is now covered by collateral, compared with 59 percent last year. The role of repo transactions in interbank trading is documented e.g. by the Euro studies issued by the ECB (2009). Interestingly, the unsecured market has contracted more than the secured market in the present crisis! The secured market contracted between the second quarters of 2007 and 2008 by 16%. Despite the contraction, the secured segment remained the largest segment of the euro money market in the second quarter of 2008, representing one third of the total turnover in the euro money market. The report (ECB, 2009, 19) explains that “This decline in the secured market, stronger even than in the unsecured market, challenges a common perception prevailing before the start of the financial market turbulence, according to which repos and reverse repos were one of the safest ways to limit credit risk and therefore the most suitable means of lending and borrowing in the money market during times of stress. However, as the quality of some securities, including various structured products, was at the heart of the financial market turbulence, it is not surprising that the turbulence also had an adverse impact on turnover in those parts of the secured market where such securities are used as collateral.” Total daily turnover in the collateralised euro interbank market using a panel of 109 banks in 2008 had been around EUR 200 billion (borrowing side). The same figure for the unsecured market had been around EUR 230 billion. For the secured market, 26% of market turnover was at an overnight maturity. In maturity-weighted terms, around 3% of the market has overnight maturity. The following two charts provide for 2007 and 2008 the maturity weighted breakdown for unsecured and secured interbank markets (ECB, 2009).

(5) Low making asset fire sales unattractive In a financial crisis, due to heightened uncertainty and information asymmetry and the shrinkage of investors who are ready to buy if they perceive bargains, liquidity of markets deteriorates significantly. Hence, it is now longer possible to sell significant amounts of assets without having to accept a large or even huge discount to some perceived fair value. In this case, even a vicious asset fire sale spiral could materialise in the sense that to obtain liquidity or to reduce total risk taking through asset sales

17 could further depress asset prices, such that in the worst case, the asset fire sales depress market prices of assets remaining on the balance sheet by so much, that after the fire sales, solvency and liquidity problems are even worse, such as to require even more fire sales, etc.

Central banks’ role Central banks can reduce the likelihood of bank default due to illiquidity, and thereby support the entire liquidity of the system, by: • Accepting a wide range of collateral for its central bank operations, with not too restrictive risk control measures (see part 9 of the lecture); • Provide liquidity to a single institution against non-standard collateral (“Emergency liquidity assistance – ELA” (see part 11 of the lecture); • Do outright purchases of illiquid assets from banks, such as to increase the share of liquid assets in their balance sheet (see part 10 of the lecture).

D. Credit crunch: reduced lending to the real sector Out of (i) fears of becoming illiquid (because of the various reasons just provided), (ii) the desire to de-leverage (because of capital constraints), (iii) higher credit risk associated with lending, banks not only restrict lending in the interbank market, but also to non-banks. This is when a “credit crunch” materialises. The following chart of the Bank of England suggests that a drop of lending is a systematic element of financial crisis.

18 Finally, also as a consequence of liquidity constraints to the real sector, economic growth collapses. For instance, the OECD slashed end March 2009 its 2009 economic forecast for the 30-nation OECD area to -4.2 percent, the worst ever since foundation of the OECD. On the real costs of financial crisis, Laeven and Valencia (2008, 24-25) extract the following figures from their databse: “ Fiscal costs, net of recoveries, associated with crisis management can be substantial, averaging about 13.3 percent of GDP on average, and can be as high as 55.1 percent of GDP. Recoveries of fiscal outlays vary widely as well, with the average recovery rate reaching 18 percent of gross fiscal costs. … Finally, output losses (measured as deviations from trend GDP) of systemic banking crises can be large, averaging about 20 percent of GDP on average during the first four years … There appears to be a negative correlation between output losses and fiscal costs, suggesting that the cost of a crisis is paid either through fiscal costs or larger output losses. Furthermore, if this correlation is proven robust, it suggests that even in the absence of significant government intervention, fiscal losses may be large due to tax revenues forgone because of higher output losses.” Thus the data of Laeven and Valencia seems to suggest that the Government should bail out the banks. This is what we seem to observe in the current crisis, with the exception of Lehman. A considerable literature has developed since the 1980s to explain the mechanics of a credit crunch, which do not only relate to the lack of willingness of stressed banks to lend (for capital and liquidity constraint reasons), but also due to problems associated with the lending relationship itself in a distressed environment. Stiglitz and Weiss (1981) remains the main reference for credit rationing (how the price mechamism to equal supply and demand fails and some borrowers doe not get the credit that they want, even with at high rates); Bernanke and Gertler (1989), focus on balance sheet conditions (solvency) of borrowers (not of the lenders) to explain why agency costs increase in a crisis and lead to less lending, and Mankiw (1986) explains how “financial collapse” can be triggered by small exogenous changes of the environment. Many elements of this literature can also be transferred to the collapse of interbank markets. What can central banks do about a credit crunch? - Understanding the credit crunch and its effects on bank lending allows central banks to adjust correspondingly their monetary policy interest rate downwards, thereby at least partially compensation the credit crunch (even if not curing it); - support bank liquidity through measures indicated in the previous section, thereby at least reducing their lack of willingness to lend due to a lack of confidence on liquidity; - maybe accept specifically as collateral the assets one wants them to originate or purchase (loans from the banks to corporates?) It may also be mentioned that the government could instruct partially or totally nationalised banks to lend – but this is clearly something beyond the responsibility of a central bank.

19 E. Mapping the financial system into accounts The previous suggests that financial crisis have a lot to do with bank’s liquidity and solvency, and with systemic interlinkages between banks and between banks and the other sectors. It seems therefore useful to represent the financial systems in accounts, to see more precisely how really the entire system interacts. The economy is normally represented as consisting of the following sectors: - household; - banks - corporates - the central bank - the Government - the rest of the world

Each of those sectors have claims and liabilities towards each other, and essentially: - debt of short or long maturity; - equity - off-balance sheet contingent claims Finally, also inter-sector linkages are relevant, in particular the financial linkages within the banking system. To understand best, let’s quickly follow up the creation of the financial system step-wise. Day 1: by inventing private ownership and the balance sheet, the household obtains a financial representation. The numeraire at this stage maybe “cattle”, but from day 2 onwards it becomes “money units”: HH Real assets 200 Equity 200

Day 2: Assume that central bankers appeared next, and issue banknotes with a value of 50 (for use by households, upon households’ demand) and bring them into circulation by purchasing certain real assets. HH CB Real assets 150 Equity 200 Real assets 50 Banknotes 50 Banknotes 50

Day 3: Corporates are created by households, maybe for the sake of efficient governance of certain activities (to manage and exploit the commons). In our example, real assets worth 60 are transferred for this purpose to the corporate’s balance sheet. HH CB Real assets 90 Equity 200 Real assets 50 Banknotes 50 Banknotes 50 Corp Stocks 60

20 Corporates Real assets 60 Capital 60

Day 4: Commercial banks appear and start interaction with households and corporates. - They are created, as previously corporates, by households. So initially, they are created as a book-keeping operation: households pay in a capital of 10 to the bank, and the bank lends this back to the household immediately. - Then, the bank starts doing banking business: it collects deposits of 10 from households, and invests this money into corporate equity (it buys from households). - Finally, the banks convince the corporates to buy back some of the equity held by the banks (5), and to refinance this through a loan from banks (Maybe the banks argue that the higher leverage increases return on equity). HH CB Real assets 90 Equity 200 Real assets 50 Banknotes 50 Banknotes 50 debt to banks 10 Corp Stocks 50 Bank capital 10 Bank deposits 10 Total 210 Total 210 Banks Corporates Corp equity 5 Capital 10 Real assets 60 Capital 55 Corp debt 5 Dep of HH 10 debt 5 Loan to HH 10

Day 5: banks and the central bank start interacting – indeed, central banks mainly interact with banks, and not with the real sector. In our example, this is done by a credit-financed selling of real assets of 30 from the central bank to banks (other balance sheets unchanged). CB Real assets 20 Banknotes 50 Claims to bank 30 Banks Corp equity 5 Capital 10 Corp debt 5 Dep of HH 10 Loan to HH 10 Liab to CB 30 Real assets 30

Day 6: A new player appears on scene, the Government. First, the Government confiscates private real assets (some ground for Government buildings) with a total value of 40 but compensates households with Government bonds. Banks convince the households to diversify their fixed income portfolio into bank bonds, so the banks issue debt of 10 and to purchase Government bonds of 10 from the households.

21 HH Real assets 50 Equity 200 Banknotes 50 debt to banks 10 Corp Stocks 50 Bank capital 10 Bank deposits 10 Gvt bonds 30 Bank bonds 10 Total 210 Total 210

State Real assets 40 debt 40

Banks Corp equity 5 Capital 10 Corp debt 5 Dep of HH 10 Loan to HH 10 Liab to CB 30 Real assets 30 Bank bonds issued 10 Gvt bonds 10

Now, we basically have a complete financial system in place. For our purposes here, it is also worth to note the relevance of interbank transactions, and in particular interbank deposits, repo, bank bonds and CDs, and (off balance sheet) derivatives. Also, banks are heterogeneous: i.e. some may have relatively less of liquidity and capital buffers than others. If we ignore heterogeneity, we could simply assume that there are five similar banks, and that interbank transactions (depo and repo of various maturity) amount in total to 25. Then, the balance sheet of each single bank would be:

Single bank Corp equity 1 Capital 2 Corp debt 1 Dep of HH 2 Loan to HH 2 Liab to CB 6 Real assets 6 Bank bonds issued 2 Gvt bonds 2 Deposits with banks 5 Liab to banks 5

To obtain a more realistic view of banks’ balance sheets and the related risks, it is useful to have a look at actual data, such as contained for instance in publications of central banks. The following is from section 2 of the statistical annex of the monthly bulletin. The data confirms the well-known maturity mismatch which is at the core of the banking business, and an average leverage ratio of around 18. Also, the importance of interbank deposits is confirmed.

22 From table 2.1 of the Statistical annex of the March 2009 monthly bulletin (in EUR billio, data as of January 2009)

Loans to eura-area residents 18.1 75 Deposits 1 6.797 Of which: Governments 986 Of which: Governments 220 MFIs 6.328 MFIs 6.842 Other 10.861 Other 9.734

Securities other than equity 4.7 47 Debt securities issued 4.90 0 Of which: Governments 1.308 MFIs 2.047 Other 1.392

Shares / Equity 1.2 06 Capital and reserves 1.78 6 External assets 4 .867 External liabilities 4 .669 Residual 3.3 04 Residual 4.14 7

Total 3 2.299 Total 3 2.299

Some interesting split-up, in particular relating to maturity

Loans non-financial corporates 4888 Deposits other FinInst (non-banks 2562 Of which: maturity < 1 year 1394 Of which fixed mat > 2Y 1400 maturity 1-5 years 978 maturity > 5 years 2508 Deposit of corporates 1482 Of which overnight 877 Loans to households 4906 Of which: housing loans: 3496 Deposits of households 5437 Of which: maturity >5 years 3411 Of which overnight 1857 Agreed maturity above 2Y 526 Out of the external assets: Loans to banks: 2271 Of the external liabilities Deposits of banks 2800

F. Wrap up questions 1. Why are asset prices so volatile? Provide some historical examples and map those into the different factors. . 2. What is the role of central bank policies for asset prices? Summarise views expressed in recent debates. 3. Why is an asset bubble burst a problem from the perspective of financial stability? 4. How can liquidity problems follow from solvency problems? What about the other way around? 5. What can central banks do to prevent “unnecessary” bank defaults? 6. Why are banks’ liquidity and solvency constraint a macroeconomic problem? 7. What can the central bank do to attenuate a credit crunch? 8. Create a balance sheet representation of the financial system with all main sectors starting from scratch. 9. Considering the actual central aggregate balance sheet of the euro area banks, what vulnerabilities do you see? What vulnerabilities cannot be seen? 10. Now, we are ready to reflect many of the phenomena touched upon beforehand in the balance sheet of banks (and other entities). This is a good reality check of supposed mechanisms crises. For instance: (i) Run on all banks; (ii) Run on individual banks; (iii) Higher leveraging of banks; (iv) Fluctuations in real asset values; (v) Effects of corporate defaults; (vi) Interbank market squeeze.

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Literature: Akerlof, G. (!970), “The Market for Lemmons: Quality Uncertainty and the Market Mechanism,” Quarterly Journal of Economics, 84, 488-500. Bagehot, W. (1873), Lombard Street: a description of the money market. Reprint 1962, London: Richard D. Irvin. In particular: Chapter II and Chapter VII part II. Bernanke, B. and M. Gertler (1989), „Agency Costs, Net Worth, and Business Fluctuations”, The American Economic Review, Vol. 79, No. 1 (Mar., 1989), pp. 14-31 Bordo, M, and O. Jeanne (2002). Boom-Busts in Asset Prices, Economic Instability, and Monetary Policy. NBER Working Paper 8966. National Bureau of Economic Research, Cambridge. Caballero R.J. and A. Krishnamurthy (2008), “Flight to quality and collective risk management”, Forthcoming, Journal of Finance. Calomiris, Charles W. and G. Gorton (1991), “The Origins of Banking Panics: Models, Facts, and Bank Regulation”, in: Hubbard, R. Glenn (ed): Financial Markets and Financial Crises (p. 109 - 174) Diamond, Douglas W., and Dybvig, Philip H. (1983), “Bank Runs, Deposit Insurance,and Liquidity.” Journal of Political Economy, 91 (June 1983), 401–19. ECB (2005), Asset Price Bubbles and Monetary Policy, ECB Monthly Bulletin April 2005, 47-60. ECB (2009), Euro money market study 2008, Flannery, Mark J. (1996), Financial Crises, Payment System Problems, and Lending, Journal of Money, Credit and Banking, Vol. 28, No. 4, Part 2: Payment Systems Research andPublic Policy Risk, Efficiency, and Innovation. (Nov., 1996), pp. 804-824. Laeven L. and F. Valencia (2008), “Systemic Banking Crises: A new database”, IMF Working Paper WP/08/224. Kindleberger, C.P. and R. Aliber (2005), Manias, Panics and Crashes, 5th Edition, Wiley, New Jersey. Mankiw, N. Gregory (1986), “ The Allocation of Credit and Financial Collapse”, The Quarterly Journal of Economics, Vol. 101, No. 3 (Aug., 1986), pp. 455-470 Mishkin, Frederic S. (1991), “Asymmetric information and financial crises: a historical perspective”, in: Hubbard, R. Glenn (ed): Financial Markets and Financial Crises, 69-108. Reinhart C.M. and K.S. Rogoff (2008), “This time is different: A Panoramic View of Eight Centuries of Financial Crises”, working paper, Harvward University. Stiglitz, Joseph E. and Andrew Weiss, “Credit Rationing in Markets with Imperfect Information”, The American Economic Review, Vol. 71, No. 3 (Jun., 1981), pp. 393-410. Taylor, John B. (2007), Housing and Monetary Policy, memo, September 2007 Wirth, Max (1883), Geschichte der Handelskrisen, Frankfurt am Main, J.D. Sauerländer’s Verlag, dritte Auflage. (Einleitung: S. 1-18) (Google - PDF of the first Edition of 1858, in which the “theoretical” summary is in chapters 10 – 12, pp. 461 – 475 – pages 7-14 + 477-490 of google pdf).

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